Questions about credit spreads!!! Help me!

[Brighton]

FWIW, the two authors of the 12-year old book that Old Nemesis referenced are not academics. It looks like one was a CTA and an educator/advisor/consultant and one was a broker.

http://www.amazon.com/gp/product/04...pf_rd_t=101&pf_rd_p=1389517282&pf_rd_i=507846

With a publication date of Autumn 2001 it's quite possible their examples and advice are based on the go-go years of the mid 1990s right up to the dotcom and telecom crash.

 

[oldnemesis]

It is a 'common belief' among option traders that option sellers, on average, do better than option buyers. They also believe that 'studies have shown this to be true'.

Where did this belief come from?

The book by Summa and Lubow is one of the early sources for that belief. The CBOE did a study (I believe it was in the late 1990's) that seemed to show this, and this is what prompted Summa and Lubow to put that in their book. Subsequently other authors quoted the CBOE, and Summa and Lubow to generate this accepted 'truth'.

The rationale that was invoked (not by the CBOE) for what the CBOE saw was that option buyers had a bias against them in the form of time decay of the value of the option, while option sellers had that working for them. All other things being equal, this biased trade outcomes in favor of option selling.

Is this truth really 'true'? Does it matter?

Probably some but not a lot. I believe (with no study to back it up) that given a reasonable market, a good trader will make money from either type of strategy and a bad trader will lose money from either type of strategy.

It IS true that theta acts in the option sellers favor and against the option buyer. But that is just one of many factors.

Also: Selling puts (and put spreads) is easier and simpler than some other option strategies, which is also part of the attractiveness, and I believe (with no data to support that belief) that simpler trades are more likely to be executed correctly and thus have a higher probability of success.

BTW the text I quoted is in the book descriptor on Amazon. I didn't want to plow through the book and find the direct quote, especially since I threw my copy out years ago.

 

[Maverick74]

Quote from oldnemesis:



It IS true that theta acts in the option sellers favor and against the option buyer. But that is just one of many factors.

Also: Selling puts (and put spreads) is easier and simpler than some other option strategies, which is also part of the attractiveness, and I believe (with no data to support that belief) that simpler trades are more likely to be executed correctly and thus have a higher probability of success.

BTW the text I quoted is in the book descriptor on Amazon. I didn't want to plow through the book and find the direct quote, especially since I threw my copy out years ago.

I understand that you are just playing devil's advocate here but let me respond to this. That statement is not technically not true as written. If your position acts favorably to you then selling is easier then buying. If your position does not act favorably then it becomes considerably more difficult to execute and get out of then for the buyer. So it's a conditional statement for one.

Two, theta for all practical purposes does not really exist. It's up there with the unicorn and the tooth fairy. The greeks were never created to measure sensitivity on individual issues. They were always meant to understand aggregate risk since aggregate risk is considerably more difficult to manage. But on a single name, theta does not and cannot work for or against you and this can be proven mathematically without any bias. When you buy or sell an option, you are speculating on distribution. That is what an option is after all. It's a measure of distribution. Do I think the average option trader understands this? Of course not. So instead the avg Joe thinks he is earning "theta" or engaging in an "income" strategy. This same guy probably attended a Carton Sheets real estate seminar on "how to buy real estate with no money down".

I think the problem with most traders is that they have been taught in life or perhaps conditioned to break things down to a simple level to understand them. Certainly that is how most "get rich quick" seminars work. This is why they come up with cool names to describe strategies and make strategies into simple 3 step processes like they are baking chocolate chip cookies with grandma over the holidays. Trading is anything but simple. But the problem is complexity is a very hard sell in books, in seminars and online courses. Complexity scares people. Everything must be broken down into red light/green light. But the irony is, the edge in trading lies in the complexity, not in the simple. This is why structure products desks at investment banks make record profits while equity desks are struggling to stay above water. This is why hedge fund managers who can locate and execute obscure trades can earn the alpha that the long only manager only reads about. But I guess it's human nature to go after the cheese right in front of you. Even if they can't comprehend that the cage is going to close after they reach it.

 

[comintel]

It IS true that theta acts in the option sellers favor and against the option buyer. But that is just one of many factors.
......

I know that you meant this, but just to be clear, it is not an advantage in the bigger picture, because the passage of time also allows the underlying market the time to move against the seller and cause him significant losses, should an adverse trend develop. So over a longer time period, he runs the risk of larger and larger losses, despite the theta decay.

In other words, the "advantage" in terms of expected decay over a longer period is offset by the increased risk of an adverse persistent move causing a larger loss over the longer period.

This is readily evident to an option seller who sells a put, and tries to hold on through a market crash, despite theta decay.

 

[justrading]

Quote from Maverick74:

I understand that you are just playing devil's advocate here but let me respond to this. That statement is not technically not true as written. If your position acts favorably to you then selling is easier then buying. If your position does not act favorably then it becomes considerably more difficult to execute and get out of then for the buyer. So it's a conditional statement for one.

Two, theta for all practical purposes does not really exist. It's up there with the unicorn and the tooth fairy. The greeks were never created to measure sensitivity on individual issues. They were always meant to understand aggregate risk since aggregate risk is considerably more difficult to manage. But on a single name, theta does not and cannot work for or against you and this can be proven mathematically without any bias. When you buy or sell an option, you are speculating on distribution. That is what an option is after all. It's a measure of distribution. Do I think the average option trader understands this? Of course not. So instead the avg Joe thinks he is earning "theta" or engaging in an "income" strategy. This same guy probably attended a Carton Sheets real estate seminar on "how to buy real estate with no money down".

I think the problem with most traders is that they have been taught in life or perhaps conditioned to break things down to a simple level to understand them. Certainly that is how most "get rich quick" seminars work. This is why they come up with cool names to describe strategies and make strategies into simple 3 step processes like they are baking chocolate chip cookies with grandma over the holidays. Trading is anything but simple. But the problem is complexity is a very hard sell in books, in seminars and online courses. Complexity scares people. Everything must be broken down into red light/green light. But the irony is, the edge in trading lies in the complexity, not in the simple. This is why structure products desks at investment banks make record profits while equity desks are struggling to stay above water. This is why hedge fund managers who can locate and execute obscure trades can earn the alpha that the long only manager only reads about. But I guess it's human nature to go after the cheese right in front of you. Even if they can't comprehend that the cage is going to close after they reach it.

Great stuff, as always. Thanks.

The books are heavy on theory and make everything look so simple and beautiful. Bit of a shock to the system when theory meets reality.

I was rather lucky that early on atticus told me that if you can't forecast price or vol with reasonable accuracy, all the theory isn't going to help.

I see you are saying the same thing in your recent posts. Might help the options newbies to not be so starry eyed.

 

[OddTrader]

Quote from Maverick74:

In order to gain a positive expectancy you need to be right on direction and magnitude or on vol. .

Quote from justrading:

I was rather lucky that early on atticus told me that if you can't forecast price or vol with reasonable accuracy, all the theory isn't going to help.

Q
http://www.cmegroup.com/education/files/Opalesque_MANAGED_FUTURES_Roundtable_Chicago.pdf

We know that of all the things that one can measure in our industry, volatility is one that is highly predictable. Everybody can tell us with some level of confidence what the range of the S&P or of any other market will be tomorrow. However, nobody can tell us which way it is going to go.

Given that volatility is highly predictable, what we do then is venture to try to forecast the volatility, translate that loosely into risk and by means of statistical simulation, we find that, on average, we are going to make about one-and-a-half times our risk and then we tell the investors, “If we are risking 15% annualized volatility, expect to make 20% per year.”
UQ

Sounds clear!

 

[trade4succes]

Wasn't it Taleb who argues that option premiums are too low?

 

[Maverick74]

Quote from trade4succes:

Wasn't it Taleb who argues that option premiums are too low?

Taleb argues that option tails are under priced because it's almost impossible to price the tails effectively. Anything extreme is hard to predict. And when he says they are under priced, he is not saying they are off by a few percent. It's usually in the magnitude of 100's of times that.

Stuff around the mean is usually fairly predictable. Anything that has a high concentration of data points around the mean. Average income, average height, average grade on a test, average wins in a baseball season, etc.

 

[oldnemesis]

Credit Spread management... an example:

This morning I exercised one of my rules about managing a credit spread:

On 6/13/2012 I sold a Jan '14 62.50/65 bear call spread on DD for a net credit of $21 per contract. I made this trade when DD projected that things were not going to be very rosy in 2013.

This morning DD gapped up on earnings news that was less bad than expected, and that it is considering selling some of its sub-optimal performing businesses:

http://finance.yahoo.com/news/dupont-reports-drop-2q-earnings-115127545.html

http://finance.yahoo.com/news/dupont-2q-mixed-may-jettison-134006254.html

http://stockcharts.com/h-sc/ui?s=DD

My total liability on DD was $250 - $21 = 229 per contract.

Rule: Whenever the stock is performing out of expectation close the trade.

Thus after the DD pulled back to the previous close (as I anticipated it would) I closed the trade at a cost of $45 per contract .

Thus I lost $45 - $21 = $24 per contract.

These numbers include commissions.

By doing this I have removed the possibility that my loss may go to the $229 total liability.

This is getting out of the way of the steam roller because it is getting a little too close. This is what makes picking up nickels in front of the steam roller a viable strategy.

 

[Maverick74]

Quote from oldnemesis:

Credit Spread management... an example:

This morning I exercised one of my rules about managing a credit spread:

On 6/13/2012 I sold a Jan '14 62.50/65 bear call spread on DD for a net credit of $21 per contract. I made this trade when DD projected that things were not going to be very rosy in 2013.

This morning DD gapped up on earnings news that was less bad than expected, and that it is considering selling some of its sub-optimal performing businesses:

http://finance.yahoo.com/news/dupont-reports-drop-2q-earnings-115127545.html

http://finance.yahoo.com/news/dupont-2q-mixed-may-jettison-134006254.html

http://stockcharts.com/h-sc/ui?s=DD

My total liability on DD was $250 - $21 = 229 per contract.

Rule: Whenever the stock is performing out of expectation close the trade.

Thus after the DD pulled back to the previous close (as I anticipated it would) I closed the trade at a cost of $45 per contract .

Thus I lost $45 - $21 = $24 per contract.

These numbers include commissions.

By doing this I have removed the possibility that my loss may go to the $229 total liability.

This is getting out of the way of the steam roller because it is getting a little too close. This is what makes picking up nickels in front of the steam roller a viable strategy.

Did you seriously sell a leap credit spread for .21?